2 What is the catalyst behind the proposed changes?The Sarbanes-Oxley Act required the SEC to do a study of off-balance sheet transactions.Lessee off-balance sheet operating leases were cited as a major financial reporting deficiency.The FASB and the International Accounting Standards Board (IASB) have formed a joint project to converge world-wide accounting rules (including lease accounting).

3 What is the primary objective of the proposed changes?To require all leases to be recognized on the balance sheet of lessees and lessors

4 Originally proposed impact on the lesseeRequired to record an asset representing the right to use the asset over the lease termRecord a liability for the obligation to pay rentalsThe recorded asset and liability require the lessee to estimate certain future events and conditions such as renewal options, contingent rents and incremental borrowing rate

5 Types of arrangements scoped out include:Leases of intangible assetsLeases to explore for or use natural resourcesLeases of biological assetsContracts that represent the purchase or sale of the underlying asset

7 Definition of lease termOriginally proposedThe longest possible lease term that is more likely than not to occur (greater than 50%)Currently proposedThe non-cancellable period, plus any options where there is a significant economic incentive to extend

9 Variable lease payments (contingent rents, termination penalties)Originally proposedAmounts were to be estimated under various scenarios and included as part of your assets and liabilities recognizedCurrently proposedHigher recognition threshold established to include certain performance based contingent rents in definition of lease payments

10 Income and expense recognition patternOriginally proposedFront end loaded expense and income recognitionCurrently proposedNo change – consideration was being given to allowing straight line recognition of lease income and expense for leases not having a significant financing element.

11 Comparison of current treatment to the proposed standardA simple example:Lease Term - 5 years, annual rent is $20,000 per yearLessee's incremental borrowing rate = 8%

12 Comparison of current treatment to the proposed standard (continued)A simple example:Current TreatmentProposed New StandardDifferenceYearLease ExpenseDepreciationInterestTotal1$20,000$14,706$7,550$22,256$(2,256)220,00014,7066,52021,226(1,226)35,40020,106(106)44,20018,9061,09452,80017,5062,494$100,000$73,530$26,470$0

13 Comparison of current treatment to the proposed standard (continued)Front ends lease expense as straight-line depreciation and imputed interest replace straight line rent.

19 Performance obligationLessor records lease receivable based on estimated lease term and contingent rents receivedPayments discounted using implicit interest rate in the leaseInterest income recognized on the effective interest methodLiability recorded for obligation to provide the use of the space and amortized over life of the lease

20 Comparison of current treatment to the proposed standardA simple example:Lease Term - 5 years, annual rent is $20,000 per yearImplicit interest rate = 8%

22 Derecognition modelLessor would partially derecognize the underlying assetResidual interest in investment property and lease receivable will be recorded to the B/S as separate assets

23 Status of proposed projectBoards continue to deliberate final revisions to the proposed standardChanges needed to lessor accounting will be considered as a separate project or later as part of this projectFinal standard still targeted for 2011

29 The New Standards (as of May 20, 2011)A Brief OverviewKey differences - OptionsRenewal & Termination Options Included In Calculations:FAS 13: “Reasonably assured” = rarely triggeredNew Standards:Original Exposure Draft : “More likely than not”Revised Proposal: Include if “Reasonably certain” based on the presence of a “significant economic incentive” to renew or terminate… so much for objective criteria …Is 95% of FMV renewal a “clear economic incentive”?High value T.I.s with remaining life would be thoughCritical / strategic business use for spaceEasier to trigger for Lab, Manufacturing, SCIF and custom space

30 The New Standards (as of April 21, 2011)A Brief OverviewKey differences – Contingent RentsContingent Rents Included In Calculations:FAS 13: CPI, Yes; Other Contingent Rents, No.New Standards:Original Exposure Draft: All included based upon probability weighted outcomes (a.k.a. the crystal ball method)Revised Proposal:CPI based on “spot” rate as opposed to probablePercentage RentOnly if “disguised minimum rent”Based on expected outcome / estimate

31 The New Standards (as of May 20, 2011)A Brief OverviewKey differences – Executory CostsExecutory Costs:FAS 13: All are excluded for both capital and operatingNew Standards:Original Exposure Draft: Executory costs replaced with “Distinct Service Components”, not same as Executory Costs“Distinct service components” not capitalized as asset / liabilityNon-distinct service components – notably property taxes and insurance – to be capitalizedRevised Proposal:Separate “lease” and “non-lease” componentsNot via Rev. Rec. / “Distinct Service Components”“Observable prices”

32 New Lease Accounting RulesExecutory / Non-Lease ComponentsCombo of Front Loaded P&L + Executory / Non-LeaseRevised proposals make current and future executory treatment the sameEffect on tenants with gross leasesMost have not removed base expenses from FAS 13 rentConstant base amounts and straight line rent have same P&L.Not the case with new standards due to front loading.Impact: More work / calculations to avoid overstating asset and liability.Creates added incentive for tenant to ensure base year costs are as high as possible because:Reduces add’l rent expense,Keeps more $ off balance sheet

49 Implementation ChallengesTransition PlanningIts sooner than most realizeLead time to gather necessary information and documentsLead time to institute corporate process / standardizationDual Standards between now and Effective DateMultiple stakeholdersLegal, risk and compliance issuesERP Financial reporting systems

50 Implementation ChallengesTransition Planning“Date of Initial Application” (DIA)Effective Date is “transition” date, but need to report based on new standard sooner, based upon comparative financial statement requirements of lesseeDetermining Your DIAIf Effective Date is 1/1/15 companies providing comparative financial statements:5 years = DIA of 20114 years = DIA of 20123 years = DIA of 2013Which leases to includeAll leases in effect on the first day of the lessee’s DIAAll leases executed between DIA and Effective Date

51 Implementation ChallengesTransition PlanningDual StandardsBetween today and Effective Date, report based on FAS13Between Date of Initial Application & Effective Date,Report based on FAS 13Track based on New StandardsSystems and reporting must therefore track both standardsAsset & LiabilityAt DIA / Effective Date the Asset & Liability equal the PV of then-remaining lease paymentsAt DIA / Effective Date the Asset & Liability are calculated using the tenant’s then-current “Incremental Borrowing Rate”Yes, this means separate calculations each year between DIA and Effective Date!